If you own shares of companies that are involved in Brazil's oil and gas (O&G) exploration and production (E&P) then you need to be aware of this breaking news. Today, March 12, 2013, The Rio Times reported on the escalating fallout in the continuing battle between O&G producing States and the federal government of Brazil over the sharing of royalties. Recently, the Brazilian federal legislature enacted a law channeling a larger share of these royalties to non-producing States. President Dilma vetoed this legislation but the veto was overridden.

Congressmen of the largest O&G producing State, Rio de Janeiro, have already begun reacting to the loss of a portion of the royalties in part by directing a letter to Rio de Janeiro governor Sergio Cabral to suspend environmental licenses for all oil production in the state. Such an action would effectively hold much of the country's hydrocarbons ransom. Without environmental licenses, exploration and production activities within the state would have to cease. This would have severe consequences for Brazil's hydrocarbon sector given that the state of Rio accounts for 67 percent of the country's O&G output.

Investors in international E&P companies can not afford to ignore this potential threat of a production halt. At the very least, significant new state taxes to offset the lost revenues can be expected to impact producers and the investment pace in further exploration and development of Brazil's vast oil and gas resources, the majority of which are located in the State of Rio de Janeiro.

I recommend that investors immediately take actions to hedge their positions against the likelihood of a significant pullback in these companies with significant exposure to this threat.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.